Hong Kong's yuan market feels the pain of China's cash squeeze

HONG KONG, June 24 (Reuters) - A sharp squeeze in China's money market has pushed up the cost of funds in Hong Kong's growing offshore yuan market, increased risk premiums on Chinese bonds and raised talk some Chinese banks are tapping the territory's market to meet their funding needs.

Even though Beijing frowns upon banks remitting yuan funds across borders for non-trade-related transactions, bankers and traders report that offshore subsidiaries of Chinese lenders appear to be drawing on a 650 billion-plus yuan ($105 billion) deposit base in Hong Kong.

Chinese banks last week scrambled to secure cash, some paying interest rates of up to 25 percent, as the central bank let cash conditions tighten sharply to help rein in rampant informal lending. The cash crunch eased on Monday, but market rates remained higher than normal.

"Formally, no such mechanism exists. But if you look at the recent behavior of market interest rates in Hong Kong, clearly some lenders are tapping the deposit pool here for their onshore needs," said a banker in Hong Kong who declined to be named given the sensitivity of the matter.

Short-dated borrowing costs in Hong Kong's offshore yuan market have spiked to a record high of more than 4 percent compared to less than 0.5 percent a month ago.

And Hong Kong's usually flourishing certificate of deposit market, which is used by Chinese banks for short-term funding needs, has seen a noticeable drop in issuance this month.

The sharp rise in the cost of borrowing will even impact the Chinese government directly, as it is set to sell 13 billion yuan of offshore yuan bonds in Hong Kong on Wednesday.

While there is little doubt that the issue, part of an annual fundrasing exercise, will find decent demand, the record low rates of recent times are unlikely.

Five-year credit default swaps (CDS) spreads for China, a market measure of risk, have widened by 35 basis points to a one-year high of 124 basis points over the past week.

That higher risk premium is flowing through to state-owned enterprises, the most prolific Chinese borrowers in the U.S. dollar markets.

The sector's CDS spreads have widened faster than the broader market. Five-year CDS of Bank of China, the clearing bank for all yuan-related transactions in Hong Kong, have blown out by more than 40 basis points to 168 basis points in a week.

"The spike in funding costs is forcing some dealers to sell their short-dated (offshore) bonds and affecting fresh flows from real money investors," said Gordon Tsui, deputy CIO at Hang Seng Investments, who manages about 1 billion yuan in assets. ($1 = 6.1329 Chinese yuan) (Reporting by Saikat Chatterjee and Umesh Desai; Editing by John Mair)